Asset allocation can make or break a person's financial future. The return on and risk of an investment portfolio is driven by two factors that are under an investor's control, such as how well he or she understands the long-­term performance and associated risk of the various asset classes like stocks, bonds, real estate, commodities, alternative investments and cash, points out MyPrivateBanking.

Summary

To view the appendix on this paper, click here.

Asset allocation can make or break your financial future! The return on and risk of your investment portfolio is mainly influenced by two factors that are under your control:

How well you understand the long-­term performance and associated risk of the various asset classes like stocks, bonds, real estate, commodities, alternative investments and cash.

How you distribute your funds across these asset classes.

It is critical to identify the right allocation for you. The correct mix of assets depends on your financial personality. Your financial personality is defined mainly by your financial goals, your risk tolerance and your psychological ability to cope with uncertainty. You have to identify if your financial personality type is conservative, balanced or long-term oriented. You could also be a combination of these types.

If you are able to identify your financial personality correctly and allocate your assets

accordingly, you can protect yourself against various grave mistakes, namely: You would not switch your financial personality during market cycles or be overconfident during market upswings or fearsome during downturns. In consequence, you will avoid constantly moving and changing your asset allocation. You would be able to keep off the hunt for quick profits, which are usually unsuccessful, by picking special stocks, bonds or rare commodities.

You would also avoid getting seduced by financial witch doctors who promise wonderful but totally unrealistic gains. Finally, you can also avoid being overly conservative and fearful during times of opportunity. All these patterns of behaviour can endanger and could even wipe out your wealth.

This guide helps you understand the different asset classes and gives you a set of practical, easy to implement instructions on how to identify your financial personality and broadly select the right asset allocation. We also advise you to choose a professional wealth manager who can support you in the process of discovering and implementing the right asset allocation. This guide is, however, not a substitute for sound professional and personalised advice.

Asset allocation makes and breaks your financial success

What is the single most important factor that drives your financial success? You may think it is the right pick of stocks or the right timing (to invest when markets are rising and to pull the money out when markets are sinking). Wrong! The single most important decision is how you distribute your wealth across the various asset classes.

Typically, asset classes are stocks, bonds, cash, real estate, commodities and alternative investments. There are also other investments that may count as asset class, e.g. foreign currencies or luxury collectibles like art. Asset classes are generally broken down into sub-categories. Stocks, for instance, can have as sub-classes large caps (i.e. big corporations with large capitalisation), mid-caps and small-caps.

Your asset allocation mainly impacts two important variables of your portfolio:

Long-term performance: Depending on your asset mix, your long-term performance is pretty much foreseeable. In a nutshell, the more you put into stocks, the higher your performance would be. Other asset classes like bonds or commodities will return less. But some caution is important: historical data is only a probabilistic indicator of the returns you can expect.

Risk: Financial risk is measured by the probability that an actual return from an investment might be lower than expected. This includes the possibility of losing some or all of the original investment.

Your asset allocation has a direct impact on the financial risk you take. Different asset classes entail returns and risks, which are not necessarily correlated with one another. Some could even be inversely correlated at certain points in time. For instance, if the global stock markets are sinking, government bonds might rally around strongly (as we saw in late 2008).

Therefore, by choosing to invest in different asset classes, the investor diversifies his risk and the volatility of his overall portfolio decreases. In other words, the ups and downs of your portfolio become less prominent and your performance curve smoothens.

Asset classes differ widely in return and risk

Before deciding on your asset allocation it is crucially important to understand the typical performance and risks associated with various asset classes. We will avoid academic jargon like “sharpe ratio”or various other Greek letters and directly look at the two main variables, namely, the average observed long-term return for an asset class and major risks that come with investing in a given asset class.

Stocks

What are stocks? Stocks give you share ownership in publicly traded corporations. If you own stock, you actually own a piece of a business. The value of the stock reflects the expected future cash flows of that enterprise.

How do stocks perform? There have been countless research studies on the long-term performance and risk behaviour of stocks. The bottom line is: in the long run stocks most likely will return 6 per cent to 8 per cent per annum on an average after inflation. This makes stocks on average the best performing asset class, better than bonds, commodities, real estate etc. The other important aspect to note is that stocks are more volatile than other investment vehicles.

Now you may ask: What does the long run mean? In most periods of history, 10 to 15 years would have been a sufficient period for stocks to outperform all other asset classes and return their average of 6 per cent to 8 per cent. In fact, if you compare stocks and bonds over any 5‑year period in the last 200 years, stocks have outperformed bonds in more than 70 per cent of those periods. If you look at any 30-year period the extent of this better performance almost touches 100 per cent. This point is especially true if you look at periods after 1945.

How about the risk of stocks? For the individual investor it is often more important to understand how much he could lose in the worst-case scenario. Again, a lot of research has been done and the bottom line is: if you wait long enough, your risk of losing money on stocks approaches zero. For instance, in any 20-year period in the last 200 years your worst return on stocks would have been an inflation‑adjusted 1 per cent per year on average.

The data cited above is taken from the markets in the US. However, the scenarios are not very different in other countries. For instance, the inflation‑adjusted returns on stocks in the UK and in Germany have been between 6 per cent and 7 per cent. Japan, being an exception, returned only around 3 per cent p.a.

Bonds

What are bonds? A bond is a debt instrument. The issuer (e.g. a company, a government or a municipality) is obliged pay the nominal value of the bond on a specified date as well as a certain rate of interest to the bondholder.

A bond has two distinct advantages for the investor: Firstly, the expected interest earnings till maturity are known. Secondly, the consequences for any bond issuer who fails to pay the interest or pay back the par value of the debt are severe. For these reasons, bonds are usually considered less risky than stocks.

How do bonds perform? Extensive research shows that the average historic returns on bonds are significantly lower than for stocks. In the last 200 years, inflation-adjusted return for long-term government bonds (10 to 30 years) has been about 3 per cent on an average. If you look at short-term bonds (below 10 years), the real returns come down to about 2 per cent. Besides, the trend has been towards lower returns over the last five decades due to higher inflation.

The returns on corporate bonds or government bonds in emerging markets may be higher, to compensate for a potentially higher risk. What about the risks associated with bonds? The risk associated with a bond depends largely on the quality of the bond issuer. If you have a corporate bond, there is always a certain risk that the company may go bankrupt and fail to pay back the debt. Government bonds are usually considered safer (particularly governments of developed countries).

However, there are examples in history where governments have implemented total monetary reforms and all debts were declared invalid, as was the case in Germany in 1923. Another risk is inflation. If you buy a bond during a time of low inflation and the inflation rises during your holding period, all the interest and part of the principal may be eaten up by rising prices. This is one of the main reasons why the inflation‑adjusted returns from bonds can be negative, even with a very long-term outlook. For a shorter‑term outlook the risk associated with bonds is usually significantly lower than the risk associated with stocks because the interest earnings and re-­‐‑payment are fixed in the case of the bond.

Real estate

What is real estate? Real estate is the legal term for property and fixed assets linked with land, such as buildings. Sometimes the word property is used for real estate. This asset class is usually divided into residential property and commercial property. In terms of value, real estate forms the largest asset class. The total market value of real estate and property is about $60 trillion whereas stocks and bonds together have a value of around $50 trillion.

How does real estate perform? Real estate is a very diverse asset class. Contrary to stocks and bonds there is no market data available from stock exchanges because real estate transactions are usually private transactions. There have been various indexes for approximating the development of real estate prices and rent income. On the whole, it seems like the returns have been historically somewhere in between bonds and stocks. Adjusted for inflation, the return on average has been around 5 per year. This data comes from the US, which has the biggest real estate market globally.

What about the risks associated with real estate? Many people believe that land and buildings are a very safe investment because you can see it, touch it and even live in it (as opposed to stocks and bonds which are merely pieces of paper). Short-term volatility of real estate may be indeed lower than for stocks or bonds since transactions take more time.

Therefore, price changes will manifest themselves not within minutes or days but over months and years. The flip side of lower volatility is less liquidity in the market, which is a risk in itself. The latest real estate crisis in the US has shown how fast and how steeply property prices can drop. Similar evidence lies in the Japanese real estate market crash during the 1980s.

Commodities

What are commodities? These are typically basic resources and agricultural products such as gold, silver, iron ore, oil, coal, coffee, soybeans, rice or wheat. As you can already make out from this incomplete list, the term commodities describes very different products or assets.

Some commodities, gold in particular, has a reputation for being a safe bet in times of economic crisis or inflation. How do commodities perform? There is considerable debate on the real performance of commodities. Commodities as an asset class are very heterogeneous, so the return on a certain commodity index or basket of commodities can vary quite significantly. One big issue is that an investor is not able to invest directly in most physical commodities like oil or soybeans because he lacks the storage capabilities. For most commodities it only makes sense to invest in future contracts traded on various exchanges. A future contract obliges one market participant to sell or buy a certain amount of a commodity at a specified date in the

future. Research essentially shows that the inflation‑adjusted return on a broad basket of commodities futures has been close to zero over the long‑term. If you look specifically at gold, the zero return in the long term has also been well established. This, despite the fact that the gold price has had wild ups and steep downs over the last 200 years.

However, it may be possible that specific commodities, specific portfolios of commodities or certain commodity indexes can have a positive return in the long‑term.

What about the risks associated with commodities?

It is widely assumed that commodities correlate inversely (negatively) or not at all with the price of stocks or bonds. For this reason some investors assume that commodities could decrease the risk of a portfolio significantly through diversification. In fact, the negative correlation has been true only during certain periods (like the high-inflation period in the 1970s and the beginning of the 1980s). At other times commodity prices have crashed while stocks came down as well (like in the recent past).

There is one specific risk related to commodity futures. It is possible to have a negative return on certain commodity future investments while the underlying price of a certain commodity may be stable or even be increasing. This is the case when the market assumes that future prices for a certain commodity will increase. As the prices get higher, it thus becomes costly to “roll” a future contract to the next period. This situation is called “contango”. It basically means that apples on trees will be more expensive than applies in the market. As a result, it can become difficult if you always have to buy apples off the tree and sell them in the market.

Alternative investments

What are alternative investments? In this guide we consider hedge funds and private equity as alternative investments. A hedge fund is typically a less regulated investment fund. Consequently, the hedge fund can use investment strategies, which are considered impossible for regular mutual funds in many jurisdictions. Private equity is an asset class consisting of investments in “private” companies (not listed on public stock exchanges). This includes, for instance, investments in operating companies or acquisitions of such companies through leveraged (debt financed) buy‑outs.

Hedge funds and private equity are asset classes that are probably the least transparent and most difficult to understand. Based on certain common features, they have been frequently clubbed together in one asset class as “alternative investments”. Some investors would even reject the term asset class for alternative investments and prefer to call it more an enrichment scheme for clever fund managers because of the high fees associated with alternative investments.

How do alternative investments perform?

There are a number of hedge fund indexes that track the performance of hedge funds. One major index shows an average annual inflation-adjusted performance of around 6 to 6.5 per cent since 1994. But public reporting on hedge funds and private equity is in many cases neither comprehensive nor validated. In addition, the available track record of hedge funds is considerably shorter than for stocks, bonds, real estate or commodities. They have been around since only a few decades. Hence, we discourage any assumptions about the average performance.

What about the risks of alternative investments? The reason for including alternative investments in a portfolio has historically been that alternative investments are not correlated or are only modestly correlated to stocks. Again, one of the major hedge fund indexes showed a decline of almost 20 per cent in 2008. This is lower than the decline of major stock market indexes but nevertheless shows a high correlation between stock markets and hedge funds.

Cash

What is cash? Cash is defined as paper currency, coins, bank balances and checks. Usually short-term investments that can be readily converted are also included under the cash asset class. One example would be money market accounts or money market funds. How does cash perform? The short answer is: badly. The long answer is: one US dollar invested in a savings account in 1801 was worth just 7 cents in inflation‑adjusted terms 200 years later. Inflation eats into your assets. Money market instruments do somewhat better, but this performance comes with an associated risk.

What about the risks associated with cash? Cash carries a low short‑term risk. Over long‑term inflation is the biggest risk. In some countries cash became worthless after a monetary reform. In essence, stuffing your mattress with dollar bills is a very bad long‑term investment strategy.

Your financial personality determines the right asset mix

The crucial question is how to derive the right asset allocation for your portfolio from a basic understanding of asset classes. There is no one correct answer to this question. A lot depends on your personal and psychological factors. The easy part about this decision is that we know fairly well from past experience how different asset classes are likely to develop over the course of time. Nobody can forecast what the Dow will be like at the end of the year, or for that matter at the end of the next five-year period. But we know that, in the long run and despite considerable volatility, stocks will most likely have a positive return, which is much superior to other asset classes. We know that government bonds of developed countries will most likely be a safe bet in the short to mid‑term outlook.

Analyse your investor personality

Years of interaction with wealthy investors have shown us that investors make one fatal mistake time and time again: They switch their financial personality at the most unfortunate point in time. During times of bullish markets they act like long‑term investors with aggressive goals and during bearish market they change their personality and become extremely conservative investors. The disastrous fact is that this change from Dr Jekyll to Mr Hyde happens often enough near the bottom of the market (becoming conservative) or near the top (becoming bullish). A fatal pattern, which has diminished the wealth of many investors. This effect has also been described over and over again in behavioural finance research.

Research shows that the personality of an investor can be mapped along three dimensions and each of them has a major impact on your investment decisions:

Investment goals: This dimension relates to your overall goals in investing your assets:

Performance goals, asset protection goals, income generation goals and so on. A conservative investor is focused on asset protection and income generation while the long‑term investor is mainly interested in growing his assets over the long term. The balanced type is somewhere in the middle.

Risk tolerance:

Your risk tolerance increases with the duration for which you can manage/endure the potential loss of a part (which could be a significant one) of your assets. The following factors determine your risk tolerance: age, time until retirement, your need to generate regular income from your assets, other sources of income, certain payments you have to make from your assets and so on. Basically, risk tolerance is determined by the circumstances of your life and your economic situation, and also by the level of risk you are willing to take for a return. These are mostly external, rational factors. A conservative investor is on average closer to retirement and depends more heavily on cash flows from his assets. Therefore he has a lower risk tolerance than the long‑term type.

Ability to cope with uncertainty: Whereas your risk tolerance is controlled by external factors your ability to cope with uncertainty relates to your psychology. Examples are trust, fear, sensitivity to bad news, insecurity about past decisions, the wish to have peace of mind etc. This is the area where behavioural psychology plays the biggest role. It is this part of an investor’s personality that can induce financial panics or out-of‑control bull markets when vast numbers of investors react in similar manner, en masse.

The conservative investor is not very trustful of financial markets. He feels highly uncertain about the volatility of markets and his peace of mind in financial matters is very important to him. On the other hand, the long-term investor would not get nervous by reading in his morning newspaper about a steep drop in the markets. Overall he is trustful that markets will eventually recover and is capable of moving on.

Investor types and asset allocation

In the following, we provide you details on the three prototypical investor types and suggest asset allocations that suit them.

Conservative

Typical goals: Wants to protect his assets over short‑term as well and generate considerable income from his assets. His targeted rate of return should not be considerably above the inflation rate, probably between 1 per cent and 3 per cent.

Risk tolerance: This investor does not like risk at all. On average, he is somewhat older and has a shorter investment horizon. If he is retired, he may need regular income from his assets. It is also probable that this investor will need his assets to fund a big project in a not-so-distant point in future.

Ability to cope with uncertainty: Peace of mind in financial matters is crucial for the conservative type. He wants to feel safe about his investments, especially in times of financial turmoil. He may also be getting nervous about assets that have appreciated significantly in value.

Recommended asset allocation: We believe that stocks should be clearly less than 40 per cent of the asset allocation and bonds plus cash should form a big chunk, typically more than 50 per cent and up to 80 per cent. Other asset types like hedge funds, real estate and commodities may be part of the portfolio but would play only a minor role of less than 10 per cent.

“Balanced type”.

Typical goals: Asset protection is important to him; however, he is willing to trade off some security for the long‑term capital appreciation of his assets. He may also require considerable income from his assets. His returns should reach 3 per cent to 5 per cent after inflation.

Risk tolerance: The risk appetite of this type of investor is somewhat bigger. He may tolerate mild losses for a limited period of time. He could be of any age but his investment horizon is usually more than two years. He rarely depends on regular cash flows from his assets.

Ability to cope with uncertainty: Uncertainty may be a problem for him if high volatility persists for a prolonged period. This type of investor may be able to stomach uncertainty for a shorter period of time or if high volatility is limited to smaller portions of his portfolio.

Recommended asset allocation: In this case we would recommend a stock allocation of around 40 per cent. Bonds would be roughly in balance with stocks. Cash should be a small proportion of the portfolio. Other asset classes like hedge funds, real estate or commodities could represent up to 25 per cent of assets.

Long term investor

Typical goals: Long‑term appreciation of his asset base. Looks for a rate of return between 6 per cent and 8 per cent  after inflation.

Risk tolerance: This type of investor has time on his side. He has a long‑term perspective. He knows that stocks (and only stocks) will bring him a real return between 6 per cent and 8 per cent over the long-term. He can also rest assured because he is generally not dependent on cash flows from his assets.

Ability to cope with uncertainty: This type of investor is not perturbed by downturns or upswings. He does not get nervous looking at falling stock‑market quotes.

Recommended asset allocation: This investor type will hold more than 50 per cent and up to 80 per cent of stocks in his portfolio, the rest being a mix of bonds, cash, hedge funds and real estate.

To determine your financial personality, we have developed a multiple‑choice test working in tandem with a group of experienced psychologists. Please take the test before you read on.

(You will find all the questions in the appendix.)

Our test determines your personality type as an investor in all three dimensions. Which personality type is closest to you? The conservative type (A), the balanced type (B) or the long‑term investor type (C). Or are you a combination of these types? Ideally, you should be of the same type (A, B or C) with respect to all three dimensions. In this case, the judgement is clear and you have some clear guidelines to design your asset allocation accordingly. In other cases you may be a conservative type A personality with respect to your goals, for instance, but in terms of risk tolerance and ability to cope with uncertainty, tend to be more like a balanced type B. In this case your asset allocation will probably end up somewhere in between type A and B.

A difficult situation arises when your test indicates that your investor personality is all over the place. We have seen quite a few cases with C type goals (more aggressive), A or B type of risk tolerance (conservative or balanced) and very conservative A type ability to cope with uncertainty (very sensitive to uncertainty and cautious). In these cases we recommend that people should reconsider their goals, as they obviously do not match with their ability to cope with uncertainty. If they fail to reframe their goals, they will typically switch their behaviour between all types of personalities, with very poor outcomes.

Just do it: How to invest in different asset classes

This guide is mainly about how you should determine the right asset allocation for you. When you have read up to this point in the guide, you should have a basic understanding of where you want to go. You should understand that changing your financial personality is not healthy and accordingly should keep your asset allocation stable over the market cycles.

In the following, we give you a few suggestions that may help you in implementing your target asset allocation in a professional and cost-efficient way.

What you should do

Diversify within an asset class: In addition to holding diverse asset classes, diversification means the presence of a good mix of various kinds of assets within an asset class. Thus, you should make sure that different regions, sizes of companies and sectors are represented in your portfolio. Diversification leads to minimisation of

risks. Thus, if you are Swiss, don’t just invest your stocks in Nestlé, Swatch or Credit Suisse, or the Swiss Market Index for that matter. Look beyond your borders to European indexes. Add some stocks from the US. Consider some stocks from emerging market as well. Also look at smaller and medium sized companies (the so-called small and mid caps).

Keep your asset allocation stable across market cycles: Let us assume you have decided to invest 80 per cent of your assets in bonds and 20 per cent in stocks. Now there is a major stock market crisis and stocks lose 50 per cent of their value. After this crash, your asset allocation will probably consist of 90 per cent bonds and 10 per cent stocks. Now is the time to reduce bonds slightly and load up on stocks to get back to your target allocation, approximately. This rule does not mean that you have to re‑adjust your assets every time the market moves by a few percentage points. This would be far too costly over a period. Just make sure that, over time, you stay broadly within the targets you have set yourself for your asset mix.

Use Exchange Traded Funds (ETFs) and other index products: These are simple but successful instruments to invest in asset classes like stocks and bonds. There are now even ETFs for certain commodities like gold. The main advantage of these products is their low cost. Since they are not actively managed, but just mirror an existing index, they will cost you about 50 per cent to 90 per cent less than comparable managed funds. When choosing an ETF, focus mainly on broad liquid indexes. Also make sure to read the fine print because ETFs may have differences in cost structure and liquidity.

Find a competent wealth manager to support you: We advise you to choose a professional wealth manager who can support you in the process of discovering and implementing the right asset allocation. This guide cannot be a substitute for professional, sound and personalised advice.

What you should not do

Avoid expensive products wherever possible: Managed funds, especially hedge funds, can have high to extremely high associated costs. Make sure to read the small print in the prospectus before you invest in such a product. Structured products can be even worse because in many jurisdictions the issuer of such products is not even required to disclose the internal cost structure of such products. There may be some exceptions when it is better to use managed funds rather than ETFs to invest. One example is the case of certain emerging markets where the existing market indexes are not very liquid or are not performing properly.

Avoid stock picking: There are only a few excellent stock pickers in the world. Warren Buffet, the most successful investor in the world, is one example who has shown a superior performance, beating the index for many decades now. There are probably a few more of these types who can beat the market because of their talent, painstaking research and an excellent strategy. However, chances that you or your wealth manager being among them are quite slim. Hence, it is better to avoid betting on single stocks.

Avoid market timing: Investors who want to time the market, try to sell assets when the market is riding high and buy them when it is very low. Some people believe they can pick the right stocks, some think they can time the market correctly. Sounds simple, but rarely works. It is always the same story: except in the case of some very talented traders, market timing is not worth the effort and in many cases even destroys wealth because of the high fees that trading can generate.

There may be an exception to this rule when an extraordinary bubble has emerged in one asset class, like technology stocks in the year 2000. Here we have an example that technology stocks were grotesquely overvalued by any standards. But even in such extreme cases it is much easier to spot the bubble ex-post rather than ex‑ante.